When people get on the property ladder through a mortgage, they appreciate that it’s a long-term process. The loan will be repaid over 20–30 years, with interest. I think generating passive income through dividends should be thought about in a similar way.
That is, it’s going to take a couple of decades of regular investing — month after month, similar to mortgage repayments — to build up a sizeable income stream. Especially in a tax-free Stocks and Shares ISA, where the annual contribution limit is capped at £20,000 a year.
However, I think it’s something well worth pursuing, as the end result could be surprisingly attractive. Here’s how someone starting from scratch today might get to £51,000 a year in passive income in just 25 years.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
Getting started
For our purposes, let’s assume that someone starts their investing journey with £5,000. This is around half the median amount that a person in the UK has in savings.
On top of this, they commit to investing £700 a month, come rain or shine. This regular drip-feeding of money into stocks would be the fuel feeding the compounding process.
It also smooths out volatility, thanks to something called pound-cost averaging. In other words, buying more shares when prices are low, and vice versa.
A £51k passive income
Investing £8,400 a year — on top of the original £5,000 — would become just under £784,000 after 25 years. But this assumes two things.
One, that an average annual return of 9% is achieved. This is slightly below the long-term S&P 500 average of 10%, with dividends reinvested (see below), but above the long-running average of the FTSE 100 (around 8%).
So, 9% is basically the ballpark average for UK and US stocks taken together. However, it isn’t guaranteed, and we don’t know what the average market return will be in future. It could be lower or higher.
Two, this figure assumes that all dividends received are reinvested. Again though, dividends aren’t set in stone and can be cut or cancelled. That’s why it is important to build a diversified portfolio.
Nevertheless, I think a 9% return is realistic. After 25 years, an investor could rejig the £784,000 ISA to focus on just dividend stocks. If they collectively yielded 6.5%, the portfolio would then be generating just under £51,000 every year in tax-free passive income.
Growing the portfolio
The question now is, what stocks could generate 9% a year (or ideally more) in future? Well, I think it’s clear that artificial intelligence (AI) is going to have a profound impact over the next two decades. So I would want exposure to this high-growth industry.
One stock I would consider for this is Scottish Mortgage Investment Trust (LSE: SMT). It aims to invest in the world’s best growth companies.
Over the past 10 years, the shares have delivered an average annual return well above 9%.
It hasn’t been a smooth ride, though. And there’s no guarantee the managers will continue beating the market, which is always a risk with investment funds.
Long term though, I think Scottish Mortgage’s portfolio will deliver the goods. Top AI-related stocks it holds include Amazon, Nvidia, Meta, ASML, and Taiwan Semiconductor Manufacturing.
Better still, investors can currently buy into this portfolio at a 10% discount to its underlying value.
